(Excerpted
with permission from Michael Sincere's book,
.)
One
of the best ways to reduce investment risk is to have
a diversified portfolio. Diversification entails spreading
your money among a number of different types of investments
or asset classes, such as stocks, bonds and cash.
Among these investments, you can diversify even further,
into large and small or domestic and international
companies.
In
the old days, financial experts used a simple formula
to help people with their investments: older people
should buy bonds and younger people should buy stocks.
As you can probably guess, it's not that simple anymore.
Many
experts now recommend that portfolios be based not
only on the investor's age, but also on the investor's
tolerance for risk and expectations for performance.
The portfolio likely will include stocks, bonds, mutual
funds and cash.
"One
of the key things is not to put all your money into
one asset or specific type of asset," says Harvey
Hirschhorn, portfolio manager of the Stein Roe Balanced
fund. "If you had put 100 percent of your money into
Asia a couple of years ago, you wouldn't be thinking
that the 1990s was one of the greatest bull markets
of all time."
When
you diversify, it prevents one poor investment from
ruining your entire portfolio. One of the most effective
ways to diversify is to invest in mutual funds, especially
if you don't have enough money to buy a lot of individual
stocks.
The
case against diversity
However, some very successful investors have made
bets on a handful of stocks and won. They say having
a concentrated portfolio is less risky than you think.
J. Morton Davis, author of From
Hard Knocks to Hot Stocks: How I Made a Fortune Through
Smart Investing and How You Can Too,
quotes Mark Twain: "Put all your eggs in one basket,
but watch that basket." If you're going to be in the
stock market, you must be willing to embrace the risk,
Davis writes. If you want to outperform the market
averages, you should be very aggressive with 30 percent
of your portfolio -- otherwise, you might as well
buy mutual funds.
Although
a diversified portfolio won't completely eliminate
risk, it's one of the best ways to protect yourself
during market corrections or crashes. You can get
help diversifying your portfolio by using computer
software programs or consulting an investment professional.
Asset
allocation
If you think diversification is a good idea, you'll
love asset allocation.
According
to many studies, most of your portfolio's return is
determined by how you allocate your assets among different
types of investments. These studies show that asset
allocation is the most critical factor in determining
your portfolio's long-term performance.
Advice
on asset allocation has changed over the years. Several
years ago, investors were told to put 50 percent in
stocks and 50 percent in bonds. Others recommended
60 percent in stocks, 30 percent in bonds, and 10
percent in cash. Then the financial experts said to
subtract your age from 100 and invest the percentage
into stocks. For example, if you are 35 years old,
you subtract 35 from 100 and you end up with 65 percent
into stocks and 35 percent into bonds. Although some
people still use this simple calculation to determine
how to divide their investments, many experts recommend
that you don't use this calculation.
Risk
and time horizon
The new strategy is to base your asset allocation
on two factors: the amount of risk you are willing
to take and your time horizon. In addition, many experts
advise that a portion of your money be invested in
stocks, no matter what your age.
Harvey
Hirschhorn believes that individuals don't always
give enough thought to asset allocation. "If you get
the asset allocation right and you have X percent
in stocks and Y percent in fixed income, that can
go a long way to provide you the kind of returns you
need over the long-term vs. a lot of shifting in and
out."
Elaine
Garzarelli, president of Garzarelli Capital Management,
agrees. She says many individuals make the mistake
of being too conservative by allocating too much into
cash. If you're younger, you should have 70 percent
or more in stocks; if you're older, you should put
in less.
No
matter what your age, you should spend a lot of time
thinking about asset allocation. Most brokerage companies
are willing to help. If you feel you need a more thorough
analysis, you can always hire an investment adviser
or financial planner to design a portfolio that meets
your specific financial needs.
